Editor's note: This week on Morningstar.ca, we present our Focus on RRSPs, where we go over what every investor needs to know about Canada's most popular savings program. Along with an explanation of RRSP basics, we will look at important issues such as whether it makes sense to defer savings, the life-cycle approach to retirement contributions, and ways to go beyond the traditional RRSP. Finally, our manager research analysts will present their favourite funds to hold in a retirement account. Check back all week for more insights from Morningstar's experts.
While the management expense ratio is the most heralded cost of fund investing, it’s not the only one. Indeed, the Canada Revenue Agency (CRA) may exact just as heavy a toll on your nest egg as the fees you pay to fund companies.
That’s because Canadian law requires mutual funds to pass along all of their profits (or capital gains) and income earned from their investments to unitholders every year. Investors in taxable accounts will have to pay taxes on these payouts, even if they haven’t sold their holdings or reinvested the proceeds in the fund. Perversely, newer fundholders may owe tax on gains that only longer-term investors enjoyed.
Investors can maximize their returns by making full use of tax-sheltered retirement accounts. RRSPs allow investors to defer taxes to the future, or in the case of TFSAs, avoid them altogether. Many think they've done so by contributing the legal maximum. However, if you haven't carefully considered which funds you hold inside--and outside--of these vehicles, you're probably not maximizing their benefits.
Making the most of your RRSP
Tax-efficient portfolios deliver the highest possible returns with the smallest possible tax bill. The goal isn't to avoid paying taxes -- you could easily do that by making no money at all -- but rather to maximize after-tax returns. In simple terms, this means keeping the least tax-efficient investments in your RRSP or TFSA.
Because tax rates are higher on income than on capital gains, income-oriented investments are prime candidates for registered accounts. Because most of their returns come from income, bond funds are generally the least tax-efficient. For instance, the average fund in the Canadian Fixed Income category returned 3.8% for the 10-year period ended in January 2017, but investors took home just 2.2% once taxes were taken into account. Taxes ate nearly 40% of investors' pre-tax returns, while inflation ate up the rest.
For similar reasons, equity funds that generate a lot of income are also worthy contenders for registered accounts. That’s especially true for some specialty categories, such as real estate. These funds invest primarily in real estate investment trusts (REITs), which pay out nearly all profits as income to fundholders. Dividend-oriented funds aren’t quite as taxing--a large portion of returns come from capital appreciation--but with substantial income, they still make sense for registered accounts.
Even though capital gains are taxed at a lower rate, they can still create tax headaches. Each time a fund sells a holding at a gain, it triggers a taxable event. Funds with buy-and-hold strategies sell less frequently, so they generate fewer gains in the process. By contrast, higher-turnover funds buy and sell frequently, which can lead to a lot of taxable gains. Turnover and tax efficiency do not correlate perfectly, but if you see fairly high turnover (north of 100%) and a big gap between a fund’s before- and after-tax returns, think twice before holding it outside of a registered account.
Our favourites for registered accounts
Morningstar’s Analyst Rating signifies the likelihood of outperformance before taxes. Because of their strategy or asset class focus, some Medalist funds could generate less attractive after-tax returns. To reap the full benefits of investing in these analyst favourites, consider holding them in a registered account.
CI Cambridge Canadian Equity (Bronze)
Lead manager Brandon Snow devotes the lion’s share of his portfolio to stable businesses with sustainable competitive advantages, but he reserves a slice for stocks he believes are temporarily mispriced. He holds stocks falling in the latter bucket for relatively short periods, leading to high turnover. Such churn contributes to heavy capital gains. As a result, the fund’s five year after-tax return has lagged its pre-tax return by 2.3 percentage points annually. To be sure, that after-tax return still ranks in the Canadian Focused category’s top decile—a testament to Snow’s stock-picking prowess. Snow says he’s emphasized long-term holdings more recently, which should slow turnover. Even so, it’s likely to remain high by the standards of its category, making it well-suited for RRSPs.
Beutel Goodman Canadian Dividend (Gold)
This offering applies Beutel Goodman’s value-oriented strategy to dividend payers, primarily in Canada, though it can hold up to 30% in U.S. and international names. Investing in foreign stocks brings diversification benefits, but it’s less attractive from a tax standpoint, as Canadians can claim a tax credit for dividend income paid by domestic companies. With 30 stocks, the fund’s concentrated portfolio carries added risk, but the fund has been less volatile than its Canadian Dividend & Income category rivals. Its veteran stock pickers, led by Mark Thomson, use their deep understanding of company fundamentals to manage risks. Their strategy of buying stocks with a large margin of safety and exacting sell discipline also dampens volatility.
BMO Global Dividend (Bronze)
Subadvisor Guardian Capital applies a quantitative approach to identifying dividend payers globally. Its quant model screens 2,000 large- and mid-cap stocks based on 30 growth, profitability, dividend, valuation, credit risk, and technical factors. But these factors alone don’t set Guardian’s process apart. The firm is distinguished by its ability to refine its process continually and generate reliable estimates of future fair value, dividend growth, and risk. The 2016 departure of Guardian’s systematic strategy research director Harpreet Singh could hobble future innovation. However, manager Sri Iyer founded the quant model in 2001 and has made notable improvements since then, which bolsters our confidence in this fund’s future.
Renaissance Global Real Estate (Bronze)
Subadvisor Cohen & Steers boast a long and successful record investing in real estate globally. The firm uses top-down research to identify attractive real estate markets and bottom-up research to assess companies’ valuation relative to the value of their holdings and potential for growth. Performance has been average since the fund’s late 2010 launch, but Cohen & Steers enjoys a longer record of success in other markets. With limited domestic exposure and heavy dividend income, the fund is ideal for an RRSP.
Steadyhand Income (Silver)
Subadvisor Connor Clark and Lunn (CC&L) is best known for its institutional capabilities, but it has tailored its approach to income-oriented retail investors at this fund. Management targets a 75/25 split between Canadian bonds and stocks, though it can vary based on valuation and macroeconomic conditions. Management benefits from diverse perspectives across CC&L’s fixed income, quantitative equity and fundamental equity groups to make macroeconomic judgments. It also draws upon the firm’s strong risk management capabilities in both asset classes. With fine long-term results, investors seeking income-generating investment without currency risk should find this fund worthwhile.
PIMCO Monthly Income (Silver)
Unlike most funds in the global bond category—and atypically for PIMCO--this fund’s objective is to deliver a steady stream of income. In contrast to less disciplined monthly income funds, management sets its payout based on the income it expects to generate over the ensuing 12-month period to avoid funding monthly distribution with return of capital. (Return of capital isn’t taxable, but it diminishes a fund’s income-generating capabilities by eroding the value of its principal.) Managers Alfred Murata and Dan Ivascyn generate income by investing in a mix of corporate bonds, including high-yield issuers, government securities, and securitized debt. The latter, a PIMCO specialty, has given the fund a big boost since its 2011 launch.
